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Economy in Brief

Weidmann OK's QE for Euro Area; How Worrisome Are Inflation Trends?
by Robert Brusca  April 11, 2014

Inflation has taken on a life of its own as a policy driver in the European Monetary Union. Jens Weidmann, President of the Deutsche Bundesbank, who has been renowned for his opposition to anything that looked like an innovative monetary policy on the part of the European Central Bank, is now in favor of a program of quantitative easing. Weidmann prefaced his comments indicating approval of the plan by noting that the German courts had vetted the proposal and found it to be consistent with the mandate of the ECB. This is a pretty clear sign that the ECB is planning to go through with a program of quantitative easing. ECB President Mario Draghi has said that any European program would include private securities as well. Expectations are that the plan could include up to 1 trillion euros in purchases by the ECB.

Ongoing sluggish growth is undoubtedly one of the problems that the ECB is reacting to, but closer to its mandate is the ongoing undershoot of inflation in the European Monetary Union. In March the euro area's HICP over three months is falling at a 0.1% annual rate, over six months it's rising at a 0.2% annual rate and year-over-year it's rising at just a 0.6% annual rate. Because of the ECB's strong adherence to inflation-targeting, lower inflation rates have not been quite the tinderbox as they have been in the United States. Europe tolerates low inflation better than the U.S. but these numbers are the cause of backlash. A year-over-year pace as low as 0.6% is certainly far distant from a target of 2%. St. Louis Fed President James Bullard, just last week, said that if inflation in the U.S. should fall to the one half of 1% range, it might be a signal for the Fed to increase its quantitative easing program and abandon tapering.

Germany's inflation at 1% year-over-year is low and lower than the 1.6% that it has averaged over the life of the ECB. Germany has run the lowest pace of any EMU member from the inception of the euro area. But Germany at his time is not the low inflation country in the Monetary Union. Inflation in France is up only 0.7% year-over-year, inflation in Italy is up only 0.3% year-over-year, and inflation in Spain is falling at 0.2% year-over-year.

German statistics show different results looking at the HICP, which is the harmonized index for all of the euro area, compared the German domestic index. The German domestic index shows inflation running a somewhat steadier and higher pace centered around 1% but still decelerating from a year-over-year pace of 1.3% one year ago. The domestic index for Germany shows that the CPI excluding energy is running at a fairly steady pace between 1.3% and 1.5% over various horizons. However, calculations of diffusion which measured the breadth of inflation show a slight tendency for inflation rates across the various CPI components to be declining more than accelerating. In short, inflation is under-target and signs point to further deceleration.

Weidmann and the Bundesbank have always had a focus on what's best for Germany. In the German view of what's best for the EMU, it is for it to follow a path quite similar to the path that traditionally has been followed by the Bundesbank. It's not clear if Weidmann's recent change of heart reflects a broadening of his sensitivity toward the rest of the euro area, but in the wake of the financial crisis it should have become clear that Germany is part of the euro area and its fortunes will ebb and flow along with the euro area even if Germany itself does slightly better than the euro area as a whole. At the moment, the German economy is doing significantly better than the euro area. While the HICP version of German inflation is quite weak, the domestic version, the headline and the ex-energy index do not show the same sense of urgency. Yet Germany is on board for a more activist ECB.

It's in looking at the inflation trends for the rest of the euro area that we begin to raise eyebrows. Troubles and deflation risks seem to be for the euro area than for Germany. The things that are quite different from what we've seen historically show more worrisome EMU-wide developments. What we are seeing is low inflation in Germany with even lower inflation in other countries in the euro area. Has Weidmann finally broadened his horizons to be more concerned about what's going on in the euro area than simply what's going on in Germany? If so this would be a real step forward for the euro area and for the ECB.

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